1. After studying this chapter, learners should be able to understand:
PUBLIC SECTOR ACCOUNTING LECTURE NOTES BY MR. S. NDHLOVU TOPIC 5 INVESTMENT APPRAISAL IN PUBLIC SECTOR
LEARNING OBJECTIVES
After studying this chapter, learners should be able to understand:
The nature of investment decisions
Different methods of investment appraisal
Procedures, advantages and disadvantages of investment appraisals

2. INVESTMENT APPRAISAL IN PUBLIC SECTOR
THE NATURE OF INVESTMENTDECISIONS
Resources have to be committed today to achieve gains tomorrow. Though it may be easy to determine how much will be committed, there is some difficulty in accurately forecasting the gains from the investment in future.
Therefore, undertaking investments involves taking risks. As money becomes available it has to be put into productive use
A greater part of management effort is taking investment decisions

3. INVESTMENT APPRAISAL IN PUBLIC SECTOR
This involves the assessment of how much should be spent on assets or project and which assets should be acquired.
It involves the assessment of the level of expected returns earned for the level of expenditure made as well as estimating the future costs and benefits over the project’s life. 
It can also be defined as a technique directed at finding out the least possible costs of an investment and maximum economic benefits which may accrue from the commitment of the resources in it.

4. INVESTMENT APPRAISAL IN PUBLIC SECTOR
INVESTMENT APPRAISAL CONT’D
Before deciding which project/assets to invest in, corporations/institutions have to compare the benefits to be derived from the acquisition/investment against the costs involved in the investment.
The investment will not purely depend upon financial aspects but to a large extent, the strategic direction of the business.

5. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Capital budgeting/investment appraisal process
Forecast capital requirements
Identify suitable projects
Appraisal potential projects
Select and approve the best alternative
Make capital expenditure
Compare actual and planned expenditure, investigate deviations and monitor benefits from the project over time

6. INVESTMENT APPRAISAL IN PUBLIC SECTOR
METHODS OF INVESTMENT APPRAISAL
There are several methods available for appraisal exercise. However, in this study we shall limit ourselves to the main technique which are:
The Net Present Value (NPV)
Pay back
Accounting Rate of Return (ARR)
Internal Rate of Return (IRR)
Cost –Benefit Analysis

7. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Net Present Value (NPV)
The Net Present Value of a project is the difference between the sum of the project discounted cash inflows and outflows attributable to a capital investment or other long-term project.  
The Net Present Value approach holds that cash received in the future is less valuable than cash received today.
When the present value of the inflows exceeds that of outflows (which includes any relevant taxation liabilities, as well as the more obvious initial investment outlay), the net present value is positive and purely on financial grounds, the investment should be accepted. In contrast, if the present value of the outflows exceeds the present value of inflows, the net present value is negative and the investment should be rejected.

8. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Net present Value (NPV) cont’d
On discounting the cash flows, we use the discounting factor known as cost of capital, discount rate or required return.
Whatever term used, the rate used for discounting reflects the cost of finance that will be tied up in the investment
Advantages of Net present Value(NPV)
It takes into account the time value of money
It uses cash flows not profits which can easily be manipulated.
Considers the whole life of the project
It is absolute measure of the return
It leads to the maximization of the shareholders wealth
Technically superior method to all investment appraisal methods

9. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Disadvantages of Net Present Value (NPV)
Non financial managers find it difficult to understand
Future cash flows and cost of capital may be difficult to forecast
There is the assumption that future cash inflows will come as predicted may not necessary be so

10. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Example
The following information has been provided to you by RDA engineer. Using the NPV method of project appraisal, advice the engineer on the project which should be undertaken.
project: A B C D
Capital year ZMW ZMW ZMW ZMW
(Outlay) year 0 (40,000) (40,000) (20,000) (20,000)
Cash Inflows 1 20, ,
2 20, , ,
, ,000
Assume the cost of funds is 5%.
   
INVESTMENT APPRAISAL IN PUBLIC SECTOR

11. INVESTMENT APPRAISAL IN PUBLIC SECTOR
(ii) Payback period
This method is often used as a ‘first screening stage. It answers the question of “ how long will it take to pay back the amount invested in a project?”
Payback refers to the time taken by the project or investment in paying back the amount invested.
It is an investment appraisal technique which focuses on the time taken by an investment to recoup the amount of money put into it.

12. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Payback period cont’d
This method favours the project with shorter pay back period.
Meaning that the project will only be undertaken if pay-back period is shorter or at worst, equal to the maximum set standard period.
For a single project, the pay back period is compared with a set standard while for mutually exclusive projects, they are ranked and the one with shortest pay off time is selected

13. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Advantages of pay back period
It is simple to calculate and understand
It uses cash flows rather than accounting profits which can easily be manipulated
It can be used as a screening device; as a first stage in eliminating obviously inappropriate projects prior to more detailed evaluation
It may be used as a safeguard against risk, particularly if the latter(risk) increases as payback period lengthens
It is a useful measure of liquidity, since the method ensures the selection of projects that provide the hope of immediate cash recoupment

14. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Disadvantages of payback period
It does not take into account the time value of money
It ignores cash flows after the payback period
It encourages managers to be risk averse by going for projects which have the shortest payback period
It is unable to distinguish projects with the same payback period
It ignores variations in the timing of cash inflows within the payback period
It may lead to excessive investment in short- term projects.

15. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Payback period cont’d
Example
The Ministry of Local Government and Housing in Zambia plans to invest in one of the following two projects. Using the payback period, advise the Ministry on the project to select.
project 1 project 2
YEAR ZMW ZMW
Initial investment(outlay) 0 (100,000 ) (150,000)
Cash inflows: , ,000
2 30, ,000
3 20, ,000
4 10, ,000

16. INVESTMENT APPRAISAL IN PUBLIC SECTOR
(iii) Accounting Rate of Return (ARR)
This is the return on initial outlay or return on average capital 
It is the average profit divided by the average investment
ARR uses accounting profits rather than cash flows.
To find the ARR of an investment, the average profit over the life of the investment is calculated and divided by average investment
The ARR is expressed as a return on either the initial or the average investment in the project.
An acceptable ARR must be specified by the decision maker in advance, indicating that projects exceeding this return will be accepted and those falling short of the return will be rejected.
Basically the project with higher ARR is selected

17. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Accounting Rate of Return cont’d
ARR is calculated using the formula:
ARR = Average annual profits
Average Investment
Where Average Investment is:
Initial investment + Residual value 2
Profit is found by deducting all necessary expenses incurred from the income.

18. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Accounting Rate of Return (ARR) Cont’d
Advantages of ARR
It is simple to calculate and understand
It takes into account the total profitability of the project i.e. throughout the project’s useful life
It express it results into percentage making it easily understood
Figures for profits and investment are readily available from annual financial statement

19. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Accounting rate of Return Cont’d
Disadvantages of ARR
It does not take into account the time value of money
It uses accounting profits rather than cash flows
Profits can be manipulated or window dressed
It ignores the fact that profits from different projects may accrue an uneven rate
It fails to carter for risks and uncertainties

20. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Accounting Rate of Return (ARR) Cont’d
Example
Lusaka City Council has provided you with the following information:
Project: project X project Y
YEAR ZMW ZMW
Profit figure: 1 1,000, ,000
2 2,000, ,500,000
3 4,000, ,000,000
4 5,000, ,500,000
Initial investment : ,000, ,000,000
Residual investment 1,000, ,000,000
Using the Accounting Rate of Return, advise the management of Lusaka City Council on the project to invest in

21. INVESTMENT APPRAISAL IN PUBLIC SECTOR
(iv) Internal Rate of Return (IRR)
This is the discount rate which when applied, gives Zero Net Present Value(NPV)
The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period
Therefore, IRR is that unknown discount rate which makes NPV equal to zero, or the sum of PVs = Co.
IRR is found by Trial and Error.
Formula for IRR:
IRR = a + NPVa (b-a) %
NPVa – NPVb
Where : a = the lower rate of the return
b = the higher rate of return
NPVa = the NPV obtained using rate a
NPVb = the NPV obtained using rate b

22. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Internal Rate of Return Cont’d
Procedures in calculating the IRR
Calculate the net present value using the company’s cost of capital
Having calculated the NPV using the company’s cost of capital, calculate the NPV using a second discount rate.
If the NPV obtained when using the cost of capital was positive, then make sure you obtain a negative NPV when you use the second rate. In such case the negative NPV would be obtained by using discount rate greater than the cost of capital

23. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Advantages of Internal Rate of Return (IRR)
It considers the time value of money
It express its results in percentage hence easy to understand
It uses cash flow not profits
It considers the whole life of the project
It can maximize shareholders wealth since the projects are selected when IRR exceeds the cost of capital

24. INVESTMENT APPRAISAL IN PUBLIC SECTOR
INTERNAL RATE OF RETURN Cont’d
Disadvantages of Internal Rate of Return(IRR)
it is fairly complicated to calculate
It is not a measure of absolute profitability
Non- conventional cash flows may give rise to multiple IRRs which means the interpolation method can not be used.
Non conventional cash flows are those where there is both inflow and outflows during years. In other words flows of cash vary or have more than one change in the sign of cash flows e.g

25. INVESTMENT APPRAISAL IN PUBLIC SECTOR
(v) Cost- Benefit Analysis
This defined as an analytical tool in decision making, which enables a systematic comparison to be made between the estimated cost of undertaking a project and the estimated value of benefits, which may be obtained from its execution
This is the most popular technique used in evaluation of projects in public sector.
The technique seeks as a minimum, the point of equilibrium between the costs and benefits of a proposed project, initiated by either the government or demanded by the populace.
It is applied in such areas as transportation, postal services, communication projects, educational projects and road construction

26. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Procedures for conducting Cost- Benefit Analysis
Examine the problem with the proper definition of the objectives of the analysis in focus
Consider alternative courses of actions, which would achieve the defined objectives in above point
Enumerate the costs involved and the benefits, which would accrue from the particular courses of action, to the establishment and the society
Evaluate the costs and benefits
Draw conclusions as to the economic and social effects of a particular choice
Re-examine the problem and the chosen objectives to determine accomplishment

27. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Advantages of cost- Benefit Analysis
It takes into consideration monopolistic power of Government over vital projects
It considers not only financial commitments on a project but also favourable and unfavourable impact of the project on society
It is a viable option for project appraisal in government, bearing in mind its service- rendering goal
The appraisal technique serves as a check on the excess of political decisions which most of the time ignore economic and social costs and benefits of a project on the society
It is easy to apply.

28. INVESTMENT APPRAISAL IN PUBLIC SECTOR
Disadvantages Cost- Benefit Analysis
Final selection of the project may be based on unjustifiable factors e.g political, social, geographical and historical factors
It requires comprehensive and intelligent data collection and analysis for which the public sector is noted to be deficient.
Dissimilar projects are not, most of the time evaluated and considered together e.g cost-benefit of constructing a road and school will not be considered, but only similar items